Dear Blog,

It’s been entirely too long and I miss you terribly. I had quite the crazy 2014, but as things are settling down now I plan to get back to you on a more regular basis.

There are so many things that we need to catch up on; I’ve been having a hard time deciding on where to start. Rather than belabor the issue though, I’m going to just jump right back in and just briefly make note of the announcement by CorpFin on Friday that, in light of Chair White directing the staff to review and report to the Commission on Exchange Act Rule 14a-8(i)(9) (allowing for exclusion of shareholder proposals that directly conflict with a company’s own proposals to be submitted at the same meeting), CorpFin will not be expressing any views on the application of Rule 14a-8(i)(9) during the 2015 proxy season.

All of this of course relates to the shareholder proxy access debate going on over at Whole Foods, which if you haven’t been following is accessibly summarized in this NY Times piece or, better yet, have a look through Whole Food’s no-action request and James McRitchie’s response and subsequent appeal (all reproduced below).

I’m sure we’ll have plenty more to discuss on this as proxy season moves into full swing.

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Accredited Investor VerificationLast Thursday the Division of Corporation Finance released its latest set of Compliance and Disclosure Interpretations (C&DIs) related to defined terms in Rule 501 of Regulation D and accredited investor verification under Rule 506(c) of Regulation D .

Rule 506(c) permits general solicitation and advertising in private offerings of securities, provided all purchasers are accredited investors and reasonable steps are taken to verify their accredited investor status.  The rule provides for a principle-based method of accredited investor verification (an objective determination in the context of the facts and circumstances of each purchaser and transaction), and four non-exclusive safe harbor methods of verification.

The first two new C&DIs address terms used in Rule 501 related to the definition of accredited investor, the remaining address accredited investor verification under various subsections of Rule 506(c) and, most notably, how you might use a principle-based verification method when a safe harbor method is unavailable.

What if a Potential Investor’s Income Is Reported In a Foreign Currency … 

If a potential investor’s income is not reported in U.S. dollars you can convert their income to U.S. dollars to determine whether they qualify as an accredited investor using either: (i) the exchange rate in effect on the last day of the year for which income is being determined; or (ii) the average exchange rate for that year. [255.48]

How Do You Account for Assets or Property Jointly Held By Non-spouses …

If a potential investor jointly holds property or assets in an account with a person who is not their spouse, the property or assets may, to the extent of the potential investor’s percentage ownership, be included in the calculation of net worth. [255.49]

The Income-Based Accredited Investor Verification

The non-exclusive safe harbor for verifying accredited investor status under the income test includes reviewing IRS forms reporting income for the two most recent years and obtaining a written representation from the potential investor stating that they reasonably expect to reach the same level of income in the current year (506(c)(2)(ii)(A)).

What Happens In That Interim Period Between Year’s End and Completion of Taxes … 

If a potential investor’s IRS forms for the most recent year are not yet available (i.e., during the period between the year’s end and when the potential investor’s taxes are complete, which could extend through October of the following year), then the safe harbor method of verification is not available.

In the alternative, CorpFin suggests the following principle-based method of verification:

  • reviewing the potential investor’s IRS forms reporting income for the two years preceding the most recently completed year; and
  • obtaining a written representation from the potential investor stating:
    • that the IRS forms for the most recently completed year are not yet available;
    • the amount of income received for the most recently completed year;
    • that such income was sufficient to qualify as an accredited investor under the income test; and
    • that the they reasonably expect to reach the requisite level of income in the current year. [260.35]

How Can You Use Foreign Tax Forms …

In a similar vein, if a potential investor is not a U.S. taxpayer then you cannot use comparable tax forms from a foreign jurisdiction in the place of IRS forms and still rely on the safe harbor method of verification.

The reason being is that in adopting the safe harbor the Commission relied in part on the fact that there are a number of penalties for lying to the IRS, thus IRS forms are likely to be sufficiently reliable evidence of income and therefore a reasonable means of verifying accredited investor status. This inference may not necessarily hold true in all foreign jurisdictions.

In such a case, CorpFin again suggests considering a principle-based method of verification, noting that you can reasonably verify accredited investor status by reviewing tax forms from a foreign jurisdiction where that jurisdiction imposes comparable penalties for falsely reported information. [260.36]

The Net Worth-Based Accredited Investor Verification

The non-exclusive safe harbor for verifying accredited investor status under the net worth test includes reviewing certain documentation pertaining to a potential investor’s assets (e.g., bank statements, brokerage statements, tax assessments, etc.) and liabilities (a consumer report from a nationwide consumer reporting agency) and dated within the prior three months (506(c)(2)(ii)(B)).

What If a Potential Investor’s Verifying Documents are Older Than Three Months …

On the asset side of things, if, for example, a potential investor’s most recent tax assessment is more than three months old it cannot be used in the net worth-based safe harbor method for verifying accredited investor status.

However, CorpFin once again suggests considering a principle-based method of verification, noting that where a potential investor’s most recent tax assessment shows a value that, after deducting liabilities, results in a net worth substantially in excess of $1 million, it may be sufficient to verify accredited investor status under the net worth test. [260.37]

How Can You Use Foreign Consumer Reports  …

On the liabilities side of things, a consumer report from a non-U.S. reporting agency cannot be used in the net worth-based safe harbor method for verifying accredited investor status, even if the non-U.S. reporting agency performs similar functions to a U.S. nationwide consumer reporting agency.

Notwithstanding, under a principle-based method of verification, CorpFin advises that you could review such a report while taking other steps to determine a potential investor’s liabilities (such as seeking a written representation that all liabilities have been disclosed) in order to determine whether the potential investor has the requisite net worth. [260.38]

Important Caveat 

The burden always remains on an issuer to demonstrate that its securities offering conforms with the requirements of a claimed exemption.

With that caveat in mind, CorpFin warns that under a principle-based method of verification if, after reviewing the relevant materials, there is reason to question a potential investor’s accredited status then you must take additional steps to verify their status in order to establish that you have taken reasonable steps to verify.

For example, if a potential investor’s income for the most recently completed year barely exceeds the requisite threshold, if there is doubt as to the reliability of information provided in foreign tax forms, if there is reason to question whether a tax assessment reasonably reflects the value of asset or reason to question the extent of liabilities after reviewing a foreign consumer report, then you must take additional steps to verify a potential investor’s status as an accredited investor.

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Chair White Offers Insight Into How the SEC Views Directors

Board of DirectorsThis past Monday night Chair White gave a keynote address at the 20th Annual Stanford Directors’ College where she spoke about the Commission’s “mindset” on certain matters relevant to directors. Here are a few highlights:

Directors as Gatekeepers

Unsurprisingly, White spoke of directors as gatekeepers on whom shareholders and the SEC rely to prevent, detect and stop violations of the securities laws.

In this role she advised that directors seek to understand their company’s business model, risks, financial conditions, industry and competitors; that they be engaged, ask difficult questions and insist on answers; that they know what both institutional and retail shareholders are thinking; that they give thoughtful consideration to shareholder proposals and voting results, even when proposals are not adopted; and that they, along with senior management, embrace ethics and honesty by, among other things, establishing strong corporate compliance programs and a robust compliance culture.

White called out audit committees in particular as “hav[ing] an extraordinarily important role in creating a culture of compliance through their oversight of financial reporting.” As an aside, audit committee members should also take note of this blurb from the Wall Street Journal (subscription required) which reports Andrew Ceresney, Director of the Division of Enforcement, as having tagged financial reporting and audit fraud as “[t]he ‘next frontier’ for enforcement actions”, noting that the Commission will be looking at both corporations and audit firms.

White also called upon directors to consider the view of regulators and what they publicly identify as important and problematic. She even suggested that directors consider visiting their regulators and seeking input from them directly.

Overall White emphasized the need for directors (and senior management) to set an appropriate “tone at the top”.

When Should Your Company Self-Report Wrongdoing?

One immediate question you will have to answer is whether what has been discovered constitutes material information that requires public disclosure.  If the answer is yes, that fact will also invariably dictate an obvious affirmative answer to broader self-reporting to the SEC.

Less obvious is the case of wrongdoing that does not rise to the level of a material event. In such a circumstance White refers us to certain of the factors in the Commission’s 2001 Seaboard statement on cooperation (outlining a number of criteria that the Commission considers when deciding whether and how to bring an enforcement action).

What is the upside to self-reporting and “sincere and thorough” cooperation with the Commission? Typically a reduced or no penalty and occasionally even no enforcement action. The downside? “[T]he opportunity to earn significant credit for cooperation may be lost” and, of course, the violation may be reported to the Commission anyway through its whistleblower program.

Internal Compliance and Whistleblowing

Finally, White characterizes the relationship between the SEC’s whistleblower program and a company’s own internal reporting process as one “designed to motivate those with reliable information about misconduct to come forward, while also encouraging them to work within their company’s own compliance procedures”.

White notes that the Commission considers whether a whistleblower first reported internally when determining the amount of any monetary award and expects that directors are “fostering a culture that affirmatively encourages and empowers employees to report wrongdoing … without free of being harassed, demoted or fired.”

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Automatic Disqualification Waivers: A Recurring Theme

Stamp of ApprovalLast Thursday Senator Sherrod Brown (D-Ohio), Chairman of the Banking Subcommittee on Financial Institutions and Consumer Protection, penned a letter to Chair White questioning the Commission’s practices and procedures related to waiver of the automatic disqualification provisions (triggered by certain civil and criminal suits as well as administrative proceedings) of the federal securities laws.*

Senator Brown, citing the recent dissenting statement by Commissioner Stein, wants to know just how many waiver provisions are available to issuers? He also wants to know:

  • whether the Commission has written policies and procedures in place for each provision;
  • the steps taken to ensure uniformity and consistency in the decision-making process;
  • whether the policies and procedures in place have been examined since Chair White’s confirmation and, if so, what are the conclusions regarding their suitability; and
  • finally what changes, if any, have been or will be made, or if no changes are to be made, why not.

Of late, the Commission’s waiver of ineligible issuer status — WKSI disqualification — has been an internally contentious topic and the subject of  increasing Congressional interest, but as Senator Brown inquires, and Commissioner Stein points out in her dissent, there are other automatic disqualification provisions from which issuers have sought and been granted waivers.

Two provisions of particular relevance to operating companies of all sizes:

  • Forward-Looking Statements — The limited safe harbor for forward-looking statements provided by Securities Act Section 27A and Exchange Act Section 21E is unavailable to issuers who, during the preceding three years, have been convicted of certain felonies or misdemeanors, or have been the subject of certain judicial or administrative decrees or orders related to violations of the antifraud provisions of the securities laws.
  • Regulation A and Regulation D, Rules 505 and 506 — The private offering exemptions afforded by Regulation A and Regulation D, Rules 505 and 506, are unavailable to issuers and covered persons who are bad actors.


* Senator Sherrod’s inquiry specifically addresses financial institutions, but let’s presume for the moment that the Commission will apply more or less the same practices and procedures to most if not all types of issuers.

See In re Royal Bank of Scotland Group, PLC (where the Commission waived RBC’s WKSI disqualification by a vote of 3-2; only the second WKSI waiver following a criminal conviction since WKSIs were first introduced almost 10 years ago); cf. Commissioner Gallagher’s opinion on WKSI waivers. In addition, just yesterday Reuters reported that Commissioner Piwowar’s approval of RBC’s waiver was, in a way, conditioned on a second update to the Commission’s WKSI disqualification framework.

 While I’m not aware of any published guidance that specifically addresses waivers of forward-looking statement disqualification, in this 2010 report (investing the Commission’s settlement with BofA in connection with its Merrill Lynch merger) the SEC-OIG notes that according to the Commission (pg. 39) forward-looking statement waivers are generally considered using the same criteria as WKSI waivers. Also notable is that the report goes on to recommend that the Commission develop and publish clear and consistent waiver practices.

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The Conflict Minerals Rule Will Take Effect on Schedule

As reported by Wall Street Journal yesterday, the U.S. Court of Appeals for the D.C. Circuit has denied the National Association of Manufacturers, et al., motion to temporarily stay the entire conflict mineral rule pending the district court’s decision on that portion of the related proceeding still at controversy.

The June 2nd filing deadline is now just over two weeks away and as of this writing only two conflict mineral reports have been filed thus far.

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